What if someone told World that they couldn't have it both ways: they could make loans that amortize to the Rule of 78ths or they could refinance them, but not both?
It is not rare for a customer to refinance an installment loan. Some companies report that they originate three times
more loans of a duration longer than 12 months in a particular year than they hold on their books at any current moment. The only way that can happen is if people are refinancing two times within the course of one year.
That is bad. But it is worse when they refinance on a loan that is amortizing to the Rule of 78ths. I expect that a lot of BankTalk readers are familiar with the Rule of 78ths, but for those that are not, I'll give a short explanation here. In the example of a 12-month loan, the borrower is credited for repaying 12/78ths of the total sum of interest in the first month. In the second, the credit is for 11/78ths. It goes on in such a way until the last period when the borrower pays only 1/78th of the total interest obligation.
The net effect is that interest payments are determined by a complicated formula that has the effect of moving principal payments back to the latter part of a loan. If a consumer pays off a loan, the difference means nothing. But if a consumer only pays for a few months before refinancing (a "rollover"), the end result is that the same monthly payment has reduced less debt.
Let's lay out the difference that develops when a borrower refinances a 12-month loan after only making four monthly payments. In such a scenario, he or she is likely to have less principal if the books were kept by the rule of 78ths. But the difference is dependent upon the actual interest rate; as the interest rate grows the difference becomes larger. The chart below shows how much more a borrower working under the Rule of 78ths owes after four months on a $10,000 loan.
When interest is only 10 percent, the difference is fairly negligible. On the other hand, it can become fairly large as the interest rate grows. For a loan bearing an interest rate of 75 percent, the Rule of 78ths increases the outstanding debt by $157 after four months. When a simple interest account is refinanced, the lower balance translates into a lower payment relative to the new one that faces the use of the 78th.
How much difference does it make when a borrower refinances a loan originally made on a 12-month term two times? Let's say that there is a refinance after four months and then another at the eighth month. Thereafter, the borrower makes twelve payments and finishes the loan after a combined period of 20 months. With a 10-month loan at 75 percent interest (not an unusual rate in some states for a consumer installment product), the difference is $333.
The Regulatory Response
Right now, regulators seem to have no answer for the Rule of 78ths. No one likes it, but some national installment lenders still use it.
One alternative would be to just make it against the law. The CFPB might be able to address that when they contemplate their installment loan rule-making. Fine. But if that approach turns out to have too many political enemies, then a second option is just to make it illegal to place the rule of 78ths on to a refinance loan. Let's call it the "Fool me Once Rule." I spent way too much time just trying to do the math on a payment schedule for such a loan. To find out how changes in interest rates impacted costs, I had to put together a one-way data table. I imagine that many people will find it too difficult to ascertain.
Is such an approach deceptive? Probably not if a company goes to great lengths to create a well-documented trail of disclosures. Nonetheless, it produces costs that bring with them no value to the consumer. As such, it is ripe for redress. Shame on the lender for doing it once....shame on any public policy system that lets a company do it twice.